Most commentators are rather negative on Bullard's view that a permanent (persistent) negative wealth shock should be associated with a permanent (persistent) decline in the level of real GDP, leaving it's long-run growth rate largely intact. Some question the logic of Bullard's explanation, but it is not inconsistent with what happens in a standard RBC model where productivity follows a random walk with drift. I'm not sure if that's what Jim had in mind (I will find out in due course), but just thought I'd put it out there. (Alternatively, see Steve Williamson.)

What I would like to talk about here is my own take on the matter, which is I think is subtly different from Jim's. In my previous post, I made the following comment:

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in housing prices should likely be viewed as "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along it's original growth path). The implication is that the so-called "output gap" may be greatly overstated by conventional measures.

I think that the crossed out part above was a mistake in light of the theory I had working in the back of my head when I wrote that paragraph. But otherwise, what I said is fine. As long as you understand the theory; which, of course, I should have explained. Let me do so here.

It is probably fair to say that when most people take a look at a time-series for real GDP, in their mind's eye they decompose the time-series into a linear trend and deviations from linear trend. It is a perfectly natural thing to do. But that doesn't make it correct.

Implicit in any decomposition is a theory. The common decomposition assumes that trend (or potential) GDP follows a smooth upward path. Trend is labeled "supply." Actual GDP (the thing we observe) obviously fluctuates around trend (something we do not observe). And since trend is "supply," it follows that actual GDP must be "demand;" and that cyclical deviations from trend (the output gap) are caused by "demand shocks." A lot of people seem to take all this as self-evident truth. Unfortunately, the "right" data decomposition is not as obvious as people sometimes like to believe.

What is another way to decompose time-series data? Personally, I find Jim Hamilton's regime-switching model an interesting way to interpret the pattern of economic development. The basic idea here is that growth is driven by productivity, and that productivity growth is subject to infrequent, but random and persistent, regime changes. (Regime changes are possible along other dimensions, of course.) Sometimes we are in a high-growth regime, and sometimes we are in a low-growth regime--a view not inconsistent with Schumpeterian growth dynamics. And while these growth shocks are not likely the only reason behind our cyclical ups and downs, this is the type of shock I had in mind when I envisioned the large negative wealth shock mentioned by Bullard.

In particular, as Joseph Zeira has shown (Informational Overshooting, Booms and Crashes, JME 1999), the switch from a high to low growth regime generates equilibrium asset price dynamics that any econometrician is likely to interpret as a price bubble that booms and then crashes. The price crash (and consequent loss of wealth) however, is driven entirely by economic fundamentals (I suspect that one could generate something similar in a model with multiple equilibria and self-fulfilling prophesies). I discuss this possibility in a bit more detail here: The 2005 Real Wage Shock. In this latter post, I raised the question of whether the apparent slowdown in real wage growth may have led property owners to revise downward their estimates of future rental income, precipitating the crash in real estate prices.

Now, maybe all this sounds a little crazy to you and, of course, perhaps it is. But it is interesting to note that some recent evidence on U.S. productivity growth, reported by James Kahn and Robert Rich, seems to corroborate my hypothesis: The Productivity Slowdown Reaffirmed (Liberty Street Economics, Sept. 2011). Here is a snippet from their opening paragraph:

Economists generally agree that productivity is the primary ingredient for sustainable growth in GDP and wages. The August productivity data release provided some clarification regarding trend--or long-run--GDP growth, but the news was not good: Following a resurgence of strong productivity growth in the late 1990s and early 2000s after nearly a quarter-century of slow growth beginning in 1973, the latest reading from a trend tracking model now indicates that slow productivity growth returned in 2004.

Thus we have found what might be called a dynamic tradeoff: either we assume rich dynamics for the cycle and consequently a trivial trend, or else we assume more complicated dynamics for the trend, consequently impoverishing the dynamics of the cycle. All intermediate cases are rejected by the data.

Interesting, don't you think? At the very least, I think it suggests there is some room for different interpretations of the cycle and that the relative merits of these different interpretations should be the subject of an open and respectful debate (I believe that this was the main motivation for Bullard's speech).

Why is understanding the true nature of the decomposition important for monetary policy? Kahn and Rich provide us with one answer to this question:

It is widely believed that the difficulty of detecting a change in trend growth contributed significantly to the economic instability of the 1970’s, as policymakers were unaware of the slowdown in productivity growth for many years, and only much later were able to date the slowdown at approximately 1973. This resulted in overestimating potential GDP (at least so the conventional wisdom goes) and setting interest rates too low, and double-digit inflation followed not long after.

It is not surprising to discover that the memory of that event weighs on the mind of some Fed presidents. Now, it happens to be my personal opinion that the inflation threat this time around is overstated (largely because this time there is a huge worldwide demand for USD and US treasury debt that is keeping inflation and interest rates low; see here). But what I, or anyone else, thinks is beside the point I am trying to make here. One of the Fed's most important jobs is to keep inflation expectations anchored. History shows that inflation expectations can change suddenly and capriciously. Whether one likes it or not, it is the job of Fed presidents to think about this possibility, and to voice concern if they see a danger of repeating past policy mistakes.

If we are indeed entering into 1970s era of relatively slow productivity growth, then current CBO measures of the output gap are likely overstated, and further LSAPs are probably not warranted. This does not mean, however, that there is no output gap, or that there should be no policies directed to those who are having a difficult time in the labor market. As I discuss here, there is considerable variation in regional labor market conditions and it is not at all clear that "looser" monetary policy is the tonic we want to employ (assuming that it will have any effect at all in current conditions). In particular, there may be ample scope for regional fiscal policies, education and retraining programs, or other more direct measures that are outside the realm of monetary policy.

Wednesday, February 8, 2012

In case you haven't seen it, you may be interested in this speech given recently by Jim Bullard, president of the St. Louis Fed: Inflation Targeting in the USA.

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along it's original growth path.This part is incorrect given the model I have in mind here.) The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.

At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.

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